A conservative Volcker Rule

Former U.S. Federal Reserve Chairman Paul Volcker listens to comments during a panel discussion, on how the current financial crisis has changed the role of central banks, at the National Press Club in Washington, Oct. 11, 2010.

Republicans generally don’t like the now-adopted Volcker rule, which prevents banks with federally insured deposits from trading for their own profit — or much else about the Dodd-Frank financial-reform law, for that matter. Recall that Mitt Romney pledged to repeal the whole magilla if he became president. Romney didn’t win, of course, and it’s no more likely that President Obama would ever sign a repeal of Dodd-Frank than it is that he would repeal the Affordable Care Act.

But that doesn’t mean Republicans don’t need an alternative financial-reform agenda, especially considering that the U.S. has averaged a financial crisis every half-dozen years the past few decades. So far for the GOP, it’s pretty much been about the three “Fs”: Fannie, Freddie, and “Feddie” — to prevent future bubbles, shutter the two government mortgage giants and shackle the U.S. central bank.

Yet it’s hard to see what that approach does to reform a Too Big to Fail financial system of growing size, concentration, and complexity. As analysis from the Dallas Fed recently pointed out, fewer than a dozen megabanks — just 0.2 percent of all banking organizations — control two-thirds of the assets in the U.S. banking industry. And if international accounting rules — which count a wider range of derivatives — were applied to U.S. banks, over half of all bank assets would be held by just three institutions: JPMorgan Chase, Bank of America, and Citigroup. These megabanks, as Dallas Fed president Richard Fisher puts it, are each capable “through a series of missteps by their management of seriously damaging the vitality, resilience, and prosperity that has personified the U.S. economy.”

That was true before Dodd-Frank, and it’s still true today. There is no reason to think that the next time a megabank finds itself in a financial pinch, government won’t find a way to come riding to the rescue in the name of systemic stability and panic prevention. “The history of big bank failure is a history of the state blinking before private creditors,” notes the Bank of England’s Andrew Haldane. But extraordinary measures by scared lawmakers may not even be necessary: Dodd-Frank allows a failed megabank, through the law’s “orderly liquidation authority,” to be kept alive for years by special U.S. Treasury financing.

There are several options that reform-minded Republicans and Democrats should consider. FDIC director and former Kansas City Fed president Thomas Hoenig has proposed a sort of super Volcker rule, which would ban banks with FDIC-insured deposits from any sort of trading or market-making, as well from owning complex securities such as the collateralized debt obligations that played a starring role in the financial crisis. Banks would be limited to well-understood activities such as commercial lending, asset management, and stock and bond underwriting. Banks would become smaller, simpler, and blessedly boring.

The Dallas Fed’s Fisher is also in favor of downsizing the megabanks and would add two additional provisions. First, limit the federal safety net — deposit insurance and the Federal Reserve’s discount window — to traditional commercial banks only. Their parent companies and non-bank affiliates would be excluded. Second, customers, creditors, and counterparties of all non-bank affiliates would have to sign a simple form acknowledging there is no federal backstop available to them.

Finally, banks should be required to finance their lending with far more shareholder equity, as opposed to money borrowed from creditors. This is how it worked in the pre-deposit-insurance era of the 19th and early 20th centuries. As Anat Admati and Martin Hellwig argue inThe Bankers’ New Clothes: What’s Wrong With Banking and What to Do About It, requiring banks to have an equity cushion “on the order of 20–30 percent of their total assets would make the financial system substantially safer and healthier.”

Reining in Fannie, Freddie, and Feddie is an incomplete, although ideologically comfortable, financial-reform agenda for the GOP. Next year would a good time to add ending Too Big to Fail to that list.

— James Pethokoukis, a columnist, blogs for the American Enterprise Institute.